Are CDS markets the euro zone’s iceberg?

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In an unfortunate turn of phrase at the height of his country’s current debt crisis, Greek Finance Minister George Papaconstantinou on Monday compared his government’s Herculean task in slashing deficits and debts as akin to changing the course of the Titanic. Sadly, we all know where the great “unsinkable” ended up almost a century ago and I’m sure, given the chance, Mr Papaconstantinou would have chosen another metaphor. But if the Greek economy (or perhaps the euro zone at large?) is to be cast as the Titanic, then what is its potential iceberg?

For some euro politicians, look no further than the sovereign Credit Default Swaps market. France’s finance chief Christine Lagarde said as much last week when she questioned “the validity, solidity of CDSs on sovereign risk” and warned speculators to be careful as regulators took a “second look” at the market and European governments closed ranks. Lagarde, of course, is not alone. You can be sure CDS are being examined long and hard by Spanish intelligence services investigating the “murky manoeuvres” in the debt markets. But what is the exact charge against CDS?

CDS are ways to buy or sell insurance on the risk of debt defaults without needing to own the underlying bonds in the first place. It’s a way of hedging your debts, if you like, without having to go through the often more complicated game of selling securities short (or selling borrowed paper). In essence, it allows you to take a bet on default without having to go to the trouble of owning the bonds you’re insuring against. Some critics, not unreasonably, would view this as the epitome of the casino capitalism that has elicited so much public outrage over the past three years . The fear is this market has become the tail wagging the dog.

About 10-years old, CDS were for years seen as a valuable bellwether of sentiment on corporate default risk. But its opacity as an over-the-counter market came in for heavy criticism during the credit crunch, mainly because it allowed speculators with no interest in the underlying securities to sow panic in the real marketplace, particularly in banking stocks, and offered them the power to precipitate the very crises they were betting on. There were also cases, most notably in attempts by Kazakhstan’s then biggest bank BTA to restructure its debts, where conflicts of interest were alleged. Some bondholders acting as creditors stood to gain more from forcing the bank default because they were substantial CDS holders too. What’s more, Commerzbank points out, many even doubt the sense of sovereign CDS markets at all because it’s far from clear who would pay out in the event of default. Insurer AIG was certainly unable to pay when the financial industry went south in 2008.

One defence of CDS is they merely allow a liquid market to anticipate future credit rating moves rather than outright defaults per se and, as such, are important not in their absolute but in their relative rankings of credit. Greek CDS prices last week indicating a one-in-three chance of default, for example, were wildly at odds with a consensus view such an outcome was highly unlikely. Yet, Commerzbank said that even the acceptance of sovereign CDS as a useful market signal still exposed some odd anomalies, such as German CDS trading cheaper than the US when the US and not Germany had control of its own printing presses.

Barclays Capital have burrowed deeper with a note called “Sovereign CDS: Cat or Canary?” They concluded that both CDS exposures and volumes are just fractions of the cash bond markets for the likes of Greece, Spain, Ireland, Italy and Portugal — only between 2% and 10% on exposures and 1% to 12% on volumes, with Portugal showing the highest CDS to cash bond ratios. And although there was a correlation between CDS volumes and widening cash bond spreads, this was unsurprising and showed no cause and effect.

However, Barclays did point out the CDS market appeared skewed toward fear and volatility. “CDS activity drops quite a bit when spreads tighten. This would suggest that the CDS market tends to be dominated by players who are looking to buy protection,” it said, adding that this was even more likely in markets like Greece where the absence of centrally-cleared cash repo markets makes many players reluctant to “short” the cash market.

It added: “We suspect as well that the mark-to-market sensitivity of a number of these players might be higher than the one of those active in the cash markets (which would tend to be dominated by longer-term, more passive
types of investor) – a factor that could generate more volatility.”

It hardly amounts to a damning case against CDS, but it certainly allows enough doubts about the efficiency of this market to warrant some public ire. If CDS does not create the problem, it seems it can sow the doubts and create the volatility than can often be self-fulfilling in these febrile financial times.

[...] debt workouts, then that would mark a significant victory for politicians who have long argued that CDS speculation — especially by those not holding the underlying debt — was a major aggravator of the [...]

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Mike Dolan is Reuters' Investment Strategy Editor in Europe. He has been a correspondent and editor for the past 20 years, working for Reuters from London and Washington DC in a variety of roles covering global policymaking, economics and investment trends.